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The Economic and Monetary Union (EMU) has irrevocably changed continental Europe over the past twenty-five years. In the early stages member states grew substantially more interconnected macroeconomically. The pressure of containing the sovereign debt crisis caused significant stress but also forged greater financial economic ties and triggered the initiation of several unconventional measures by the ECB. Being at the intersection of the macroeconomy, national and European policy making and being the transmission and increasingly the playground for the ECB’s monetary policy, the Eurozone bond market offers an empirically rich auditorium for chronicling EMU’s financial economic history.
A CEPR Discussion Paper recently published by us empirically determines the factors that have influenced Eurozone government bond spreads and finds that there has been a growing disconnect with marco fundamentals over the course of EMU’s history. In fact, spread dynamics are much better explained by market risk-based factors. Most importantly, it is shown that the ECB has waged a mounting influence on Eurozone government bond spreads. Empirically, the transition moment is authenticated in 2012/2013. This coincides with the shift in the ECB’s monetary policy, from conventional to increasingly unconventional, that occurs under two sets of ECB Presidents, Duisenberg / Trichet and Draghi / Lagarde.
In our recent CEPR Discussion Paper (hereafter, Eijffinger and Pieterse-Bloem, 2022) we document the research journey that we have taken to establish, empirically, what the fundamental drivers of the spreads in yield of 10-year government bonds of the ten Eurozone member states relative to the Germany 10-year Bund have been, and what additionally the influence of the ECB’s policies has been on those spreads. Already some years into the monetary union, when these bond spreads converge, several authors start to explain this, mostly through macro economic factors. The importance of financial linkages and market sentiment factors swells the closer studies near the global financial crisis. When this crisis evolves in Europe into the sovereign debt crisis in 2009 and EMU convertibility risk rises (as per Eijffinger et al., 2018), a rupture between core and peripheral Eurozone countries becomes visible and an important topic for studies. From this vast field we regard Gomez-Puig et al. (2014) as a benchmark study, as they have tested the importance of macro fundamental factors for these spreads with the most comprehensive set of variables for 1999 to 2012. Another strand takes the approach to determine Eurozone sovereign bond spreads through risk factors that are commonly accepted to drive bond returns. Credit risk and liquidity risk are the main ones, occasionally complemented with international market risk or volatility risk and exchange rate risk. Afonso et al. (2015) combines such market risk factors with macro economic drivers in a similar multifactor model structure as Gomez-Puig et al. (2014) and is another benchmark study for us.
Both strands document early evidence that the ECB’s early policy response to the sovereign debt crisis tightened government bond spreads. Following Draghi’s “whatever-it-takes” statement in 2012, the impact of the ECB’s monetary policy on the spreads quickly grows into a field of its own. Studies that control for their time-varying heterogeneity in a multidimensional factor structure and still detect a sizeable effect from the ECB’s asset purchase programs such as Afonso et al. (2018) and Afonso and Jalles (2019) are good benchmark studies for us. All in all, do we determine the drivers of Eurozone government bond spreads in a multidimensional factor structure through a time-series regression model that enables factor-specific, time-specific and region-specific heterogeneities and a general-to-specific empirical approach, similar to Gómez-Puig et al. (2014) and Afonso et al. (2015). Our general unrestricted model encompasses the relevant category of factors for a Macro Fundamental-based (MF) model and a Market Risk-based (MR) model. Factors are in turn described by a set of selected variables. The general-to-specific approach to identify the best specification for the model uses all in a generally unrestricted linear fixed-effects regression, and step-wise excludes variables for lack of statistical and economic significance....
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